Mitigating Procyclicality due to Minimum Capital Requirements in the Swedish Banking Sector

This study explores methods for mitigating procyclicality due to calculations of minimum capital requirements to cover credit risk. The basis for calculations are provided by the Basel Committee in the Basel accords and the main concern is that they could strengthen the amplitude of economic cycle fluctuations. Our study constructs a portfolio that aims to replicate the Swedish market for corporate lending by using external Probability of Default data for Swedish companies in the span of 2005-2013. The data is used together with the Basel guidelines for calculations to compute the corresponding minimum capital requirements series, which in turn is used in testing four different options to prevent the apparent procyclical behaviour. The evaluation of the options is conducted by comparing the root-mean-square deviations of the adjusted series with respect to the Hodrick-Prescott trend of the unadjusted series. It turns out that adjusting the input with logistic regression or the output with a business multiplier are the best performing options, where the latter is favoured due to its simplicity in implementation. Key Words: Credit Risk, Procyclicality, Regulatory Capital, Minimum Capital Requirements, Basel III, Economic Cycles, Probability of Defaul